From Dr Keynes to Financial Bloodletting

by Antoine Cerisier & Marc Morgan

“There is no alternative” (Margaret Thatcher)

“Doctors often invent diseases which do not exist” (Eugène Ionesco, Rhinocéros)

Bloodleting in the Middle Ages

Bloodletting was a common medical practice until the late 19th century, involving the withdrawal of blood from patients to prevent illness. Despite its inefficacy, this custom was very popular in Europe, the United States and the Middle East for more than 2000 years. Leeches were often used to remove so much blood that patients usually fainted; some died from this dangerous and ignorant treatment. Crooked doctors who practised bloodletting were often mocked and condemned by French playwright Molière in his 17th century theatre plays. In 21st century public policy, the medical removal of blood gave way to what could be described as financial bloodletting – or in other words, neoliberal austerity measures. The analogy seems a bit far-fetched but is worth looking into. Like bloodletting, austerity remains a common practice despite poor social and macroeconomic results around the world: recession, poverty, debt increases. Like bloodletting, painful solutions are considered more efficient; the more patients suffer the better. Replace blood with welfare and leeches with spending cuts and the analogy is complete.

How did we come to this? Let us first assess the moral roots of austerity, as depicted in a recent article of Le Monde Diplomatique. Numerous historians and philosophers have studied the religious sources of capitalism and austerity. For instance, German philosopher Max Weber argued that capitalism and submission to authority were strongly influenced by religious principles. French theologian Jean Calvin even believed that workers and farmers should remain poor to stay closer to God. Calvinist and Lutheran concepts of sacrifice and predestination remain deeply entrenched within the corridors of power – especially in the German-speaking world. But while asceticism and sacrifice may be respectable principles for individuals, they are no sound basis for economic policy and often have disastrous consequences. Besides, the current austerity fashion – epitomised by the European Stability Treaty adopted by Ireland on 31 May – does not affect all levels of society equally: in 2010, the top 40 French CEOs increased their earnings by an astonishing 35%. In short, the foundations of austerity lay not so much in reason as in ideology and short-term, irrational behaviour fuelled by self-interested pressure groups.

Calvin: the first “austerian”?

But things have not always been this way, as economic history teaches us. Under the influence of J.M. Keynes and his followers, virtually all Western states adopted interventionist policies and pursued largely state-led development for decades. President Roosevelt was one of the first heads of state to put Keynesian ideas into practice. His New Deal policies included radical reforms which led the way for the American economy until the 1970s: public investment in huge construction projects, high taxes on corporations and wealthy individuals, strong regulation of the financial sector. While the long-term impact of Roosevelt’s New Deal has been debated, most historians agree it played an essential role in ending the great financial crisis of the 1930s; besides, it strengthened the United States’ position as the world’s main economic superpower. This strategy was widely reproduced in Western Europe just after the Second World War. Despite colossal public debt, war destructions and trauma, most European countries constructed their Welfare States in the late 1940s and early 1950s, as Stéphane Hessel observed in his book, ‘Indignez-vous’. In Britain, the Labour government led by Clement Attlee – often remembered as one of the great British Prime Ministers – undertook major economic reforms from 1945 to 1951. Largely inspired by William Beveridge’s work, C.R. Attlee nationalised major industries and created the National Health Service (NHS), maintaining full employment and raising living standards to unprecedented levels. In other countries, even Conservative and Christian Democratic leaders implemented similar reforms – it was De Gaulle and the Conseil National de la Résistance who introduced social security in France as early as 1945.

Richard Nixon

The implementation of Keynesian policies in the post-war period also relied on a peculiar social contract which must be understood in the context of the Cold War. Indeed, the political and economic ruling classes feared a Soviet-like revolution and made concessions to workers and their trade unions – thus improving labour rights and raising living standards in Western Europe. This consensus prevailed for decades thanks to spectacular results throughout the so-called ‘Trente Glorieuses’; Germany’s ‘Wirtschaftswunder’ (economic miracle) was particularly striking. Keynesianism also spread to other parts of the world with Japan and East Asian tigers like South Korea adopting state-led development strategies; some emerging powers such as Brazil have now followed suit. Nonetheless, another ideological stance has been dominating policy and academic debates in the past three decades – namely neoliberalism. Austrian and Chicago School economists like Hayek, Von Mises and Friedman advocated neoliberalism as early as the 1950s. However, their theories were only implemented from the 1970s onwards, either through elected Conservative leaders such as Margaret Thatcher or through IMF-led austerity programmes imposed on the developing world. Despite past and present failures – some of which will be addressed in this article –, austerity is still regarded as common sense while Keynesian policies are cast a blind eye. Two quotes epitomise this radical change: in 1971, Republican President Richard Nixon admitted “we’re all Keynesians now”; thirty years later, New Labour politician Peter Mandelson insisted “we are all Thatcherites now”, as “globalisation punishes hard any country ignoring the realities of the market”.

Peter Mandelson

Whatever the motivation for this change, justification cannot be found in the post-war experiences of either the US or the UK, as austerity policy did not figure in either country’s debt reduction strategies, both running considerable budget deficits (see table, e.g. 124 percentage points of the reduction in the UK was attributed to budget deficits). By the end of the Second World War both countries faced alarming debt crises (US public sector debt was over 120 percent of GDP, while in the UK it almost reached 300 percent), but neither used the excuse that it ‘could no longer afford policies to support its citizens’ so as to cut spending, nor did the rest of Europe which was in ruin and facing a mountain of debt, as mentioned above.

Sources of the total debt reduction of the US and UK during the period 1946-1976. E.g.: 124 percentage points of the reduction in the UK was attributed to budget deficits.

Justification for this prescriptive course of action could neither have come from the effects of its doses in the past. The evidence of austerity failure where it has been tried is strong. Over the past three decades, IMF-led ‘rescues’ have commonly included the reduction of budget deficits by cutting down on public spending and increasing consumption taxes, implementing structural reforms in the labour market so as to make hiring and firing easier, reducing high-end taxes and deregulating finance. But theoretical irrationality coupled with empirical ignorance can be economically reckless. The experiences of the developing world debt crisis in 1982, the 1994 Mexican crisis, the 1997 Asian crisis, the Brazilian and Russian crises in 1998 and the 2002 Argentinean crisis, as highlighted by Cambridge economist Ha-Joon Chang, bear witness to a failed austerity policy rather than simply to ‘failed states’. The prolonging of the Great Depression through the 1930s was a direct consequence of rapid austerity policy, while the developed world remained largely in recession. The story is not too dissimilar today. Europe after only mildly recovering from its worst financial crisis since the 1930s is slashing budget deficits and has even enshrined the measures into regional law. Without coincidence, half of Europe is estimated to be in recession. The case of Greece over the past few years only exacerbates the failure of obsessive budgetary order. European austerity policy has been a triple failure in the Hellenic Republic: economic (deepening recession, higher debt), social (increased poverty, civil unrest and inequality) and political (neo-Nazis in Parliament).

So wherein lays the justification for austerity? With traditional bloodletting, the justification laid with efficiency – combating pain with more pain – as the identified symptom was human deficiency rather than the conditions in which humans lived; therefore there was no question of trying to improve living conditions. With financial bloodletting the same principle of efficiency is present. Rational spending means efficient spending, which requires the private economy and the state not to spend more than it earns, like a household. It has been common for doctors of financial bloodletting to employ the household analogy. But it is a flawed analogy – flawed for two reasons. Firstly, a household, in a capitalist market society, can normally spend more than it earns by buying on credit in order to improve the welfare of its members – it buys property on credit, pays for its children’s education on credit, etc – credit being the lifeblood of a capitalist market society like ours. Why then should the state, in the same society, not be able to avail of credit in order to improve the welfare of its citizens? Secondly, the dynamics of an economy are vastly different to that of a household. In a private economy, one individual’s spending is another’s income. This is not the case in a household. In fact, the only part of the analogy that is true is where the state, or private economy, and the parents of a household reduce their spending, making each of their dependents worse off. In the household for example, if the parents are forced to reduce spending on their child’s education, then the child becomes worse off.

So when will European leaders learn from their mistakes? Punitive economic treaties will not solve the current debt crisis, or the wider social crisis in Europe. They may only deepen them. Rather, rational policy and a policy that is ethically sound, amid unethical circumstances, usually turns out to be good economic policy. This is what European leaders can learn from Iceland, a country which took its economic, political and social problems into its own hands. On the economic front, the Icelandic public unanimously rejected the orthodox adjustments that the IMF wanted to impose as it was called upon for financial assistance by the previous conservative government in the aftermath of its financial crisis in 2009. The electorate twice rejected, in 2009 and 2011, a bank bailout, becoming the only European country not to socialise private bank losses and foreign bondholder debts. This has allowed for a huge write-down of private sector debt, which otherwise would have become public debt, as happened in other European countries now facing sovereign debt crises and severe social cutbacks. Much less severe austerity is thus being experienced in Iceland, as its priority was to preserve its welfare state. For example, its social security system has remained intact. On the political and social fronts, justice was sought after four private bank executives and three former government ministers, including the former prime minister, were brought to trial. Furthermore in 2010, on the arrival of the new government, a national assembly was put in place comprising of 25 democratically elected “ordinary citizens” responsible for collecting and drafting 700 pages of ideas and proposals for reforming the 1944 constitution, crafted by the citizens of the country through social networking sites and a National Forum. What this comprehensive social endeavour brought was a more credible pact with the IMF, adapted to Iceland’s own proposals. “The authorities compromised to implement the agreed policies, but they wanted to do it their way. One of the primary objectives of the government was to protect the welfare state, and that objective has been achieved”, according to Poul M. Thomson, deputy director of the European Department of the IMF overseeing the unconventional measures agreed to “in record-time” by the Fund and the Icelandic authorities representing the population. Iceland’s economy has since grown at its fastest rate since the global financial crisis.

Icelandic citizens demonstrating in 2010

If the European Union, and especially the Eurozone, were serious about solving their debt problems they might take after Iceland in writing-down some of their debt. Continuing with financial bloodletting will not kill the disease, but rather kill the patient. They might also look for ‘domestic’ solutions, proposed by ordinary citizens, which a majority could relate to. An example of such a medium is ‘Roosevelt 2012’, a collective of French economists, politicians, philosophers and artists, including Stéphane Hessel and former Prime Minister Michel Rocard as founding members. The Collective was formed earlier this year and has to date collected over 65,000 signatures. It has proposed 15 immediate reforms, taking inspiration from President Roosevelt when he came to power in the US in 1933. As an example, their first proposed reform seeks to tackle the real root of the current wave of fiscal austerity, what is otherwise known as ‘carry-over trade’ – where private European banks borrow at a rate of between 0 and 1 percent from the ECB, and lend to individual countries at rates between 6 and 7 percent, thus crippling the fiscal position of states and allowing private banks to make huge profits. What the Roosevelt 2012 collective propose is that the ECB lend, instead, to the European Investment Bank (EIB) at a rate of 0.01 percent, and that the EIB in turn lends to sovereign states at a rate of 0.02 percent. This simple measure could be carried out from next week, without revising any existing European treaty, and would permit the elimination of primary budget deficits in countries like Italy and Spain.

They have decided to act. Shall we?

The other reforms, dealing with budget crisis, unemployment and the threat to the European social model, convey a feasible return to a framework that has in the last three decades been abandoned, as well as new innovative measures for the future. The practice of financial bloodletting by current economic and political doctors ought to be condemned, as Molière did with the medical doctors of his day, and be replaced instead by a policy that is rationally acceptable and empirically backed. There is indeed an alternative to punitive economics, and today it may be found in the midst of ordinary society.

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  1. Robert Friedman said:

    Two issues I have with this. It makes no reference to the need for structural reform in the Eurozone, particularly with regard to labour markets and elements of the welfare state. Secondly, Iceland should be marketed as the “least worst” resolution to the current crisis. The Icelandic economy suffered a GDP decline of close to $10 billion dollars in the aftermath of its banking default. Moreover, ordinary citizens suffered losses in their savings and a decline in living standards comparable if not worse than those experienced by citizens of countries currently undergoing financial bloodletting. Nonetheless, a fantastic article!

  2. Robert,

    Thank you for your comments, and I’m glad you enjoyed the article.

    I think there needs to be caution surrounding structural reform and clarity in what exactly one means by it. ‘Structural reforms’ are any changes to the structure of an economy, which can range from changing the ownership of resources, increasing openness and transparency, improving financial regulation, corporate restructuring, labour and capital market liberalisation etc. I think the change in lending practices of the ECB, in which we discussed one proposal, can be characterised as a structural reform. The article did focus very briefly on structural reforms imposed by the IMF in developing countries. Their failure has been well documented.

    By structural reforms in the labour market and in elements of the welfare state, I suspect you mean lowering labour costs (wages, taxes, social insurance, health insurance, retirement contributions…), making it easier to hire and workers and limiting the wage bill of the state? I don’t particularly favour complete liberalisation of labour markets in times of crisis. The results of this policy in developing countries has not been positive for employment. I think here is when the welfare state needs to have a strong hand. Unfortunately this hand is weakened by excessive debt obligations which needs resolving. However I would favour certain reforms in the labour market to safeguard employment and demand – which should be the primary concern. One would be to minimize redundancies by reducing the working hours of workers (both in the private and public sectors) instead of firing them, which is costly for the firm and the state. This is something Germany has done since the crisis and which the Roosevelt 2012 collective has also proposed. Another structural reform I would see as necessary would be for Germany, and other countries with similar labour markets, to accept higher wages and thus higher inflation, which is needed. This would be equivalent to an internal devaluation in the peripheral economies, and would make more sense than for them to have to decrease wages further. Another measure concerning the labour market that could be carried out to protect employment would be to pass a law stating that all precarious work be made into permanent contracts after 3 or 6 months, and that precarious workers cannot account for more than 5% of firm’s labour.

    On the topic of Iceland, I agree that it should be ‘marketed’ as the “least worst” resolution; it was careless of me for not having made that more explicit. Of course the route they took was not ideal, however under the circumstances and considering what is classically understood as good economic policy by the mainstream – whatever results in positive and sustained growth – Iceland has been the country to rebound the quickest in Europe, alongside the other Nordic countries, who incidentally possess the most generous welfare states on the continent. This is justification that ‘big welfare states’ act as automatic stabilizers during a downturn. We did point out however that Iceland underwent cutbacks, but they have been much less severe than those of the other countries, given Iceland’s debt write-down. Your figure for the decline in Icelandic GDP seems way too high. Eurostat and World Bank data have the post crisis decline at roughly $4 billion. The first private bank debt default came in 2009, a second in 2011. Since 2009 the economy has only strengthened and particularly since 2010, being verified by the data. Some citizens may have lost savings (I would like to see evidence on this), but the large majority had their savings guaranteed by the government. I do not wholly accept your claim that ‘ordinary citizens suffered…a decline in living standards comparable if not worse than those experienced by citizens of countries currently undergoing financial bloodletting’. Icelandic standards of living did fall, but from a previously high level; it still presides over a standard of living higher than that of Greece, Italy, Portugal, Spain, France or the UK (if you take GDP per head). As pointed out by the IMF, academics and Iceland’s own government, the country’s welfare state has remained very much in tact, with little or no decline in social security for example. And the economy is recovering quicker, with an unemployment rate that has remained quite stable since 2009, and falling since 2011, compared to other crisis stricken countries, like Ireland, whose unemployment rate has risen since 2009 and whose economy has been stagnant over the last few years. So while Iceland’s path was not ideal, it was surely more positive than the austere path undertaken by the EU countries.

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